Deflation: Impact on seniors? Is it necessarily bad?

In a nutshell

For seniors on a (nominal) fixed income or COLA indexed income a downward trending inflation or even a mild case of deflation might actually turn out to be beneficial. Seniors who tend to have relatively more conservatively invested retirement savings and/or are beneficiaries of fixed income streams (e.g. government or corporate pensions or annuities) the corrosive effect of taxes (especial on interest income outside tax-sheltered vehicles) actually decreases as inflation decreases or mild deflation sets in.

The details

Recently, the chorus of those predicting deflation and associated Armageddon has been getting louder and louder.

If we are in fact going into a mild deflationary period, and nobody really knows for sure if, when and for how long that would be case and whether we’ll have a serious inflationary period after that as a result of all the quantitative easing taking place, mild deflation is not necessarily bad for seniors.

The interest rates available in the market on GICs/CDs, or government bonds have been falling dramatically. Some commentators even suggested that some governments are using low interest rate policies as a means to solve their massive deficit problems on the backs of retirees, who being more risk averse have to rely more heavily on fixed-income investments. However, what really counts is the real (not nominal) interest rate and lower inflation actually helps improve the after tax return. Specifically, the corrosive effect of taxes (especially on interest income outside tax-sheltered vehicles) actually decreases as inflation decreases or mild deflation sets in.

Impact of deflation on retirees

Consider some thoughts on the likely impact of deflation:

-lower corrosive “senior inflation” (I’ve discussed Senior Inflation in blog some years ago exploring the differences between the CPI that you typically read about, the actual inflation that is experienced by seniors in general, inflation experienced by seniors in a particular city and the inflation associated with your personal basket of purchases)

-if pension un-indexed or partially-indexed, then deflation or decreasing inflation improves the purchasing power of the pension

-fully indexed pensions will get no COLA (Social Security, OAS, CPP…) when CPI shows deflation (but the buying power of each dollar should be stable or improving)

-no income tax on imaginary “nominal” returns

-real estate prices are down, stocks likely down, bonds up (yields down)

-inflation protected bonds (TIPS and RRBs) only new issues are protected (older issues with principal already adjusted upward as a result of the inflation to date, can even decrease in value should actual deflation set in)

-un-indexed annuities have improved purchasing power in deflation

-debt is bad since you have to repay cheap dollars with expensive dollars (plus interest) (So one of the best ways to prepare for deflation is to pay off your debts)

-equity and fixed income investment returns: If things change and we suddenly found ourselves in a situation of (growing) inflation, stocks tend to perform better than bonds, since bonds lock investors into a fixed nominal return rate whereas operating companies tend to be able to increase prices and earning by (by partially or fully) passing through their increased cost via price increases. In decreasing inflation or deflationary environment having locked in higher long-term bond yields in earlier higher inflationary periods is obviously of advantage.

Scenario analysis

Here are some simple ‘back-of-envelope’ type calculations. Assuming a retiree’s Tax rate=30%, Bond Return=Inflation+2%, Stock Return=Inflation+6%.(The assumed returns are something like historical: long term government bonds’ real return of about 2% and equity risk premium (geometric) 4% on top of bond rates.)

Scenario 1: Asset allocation Stock: Bond=35%: 65%

Then for each 1% reduction in inflation we get:

-lower pre-tax return by 1.0%,

-but after-tax nominal return by decreases only 0.75%

-0.25% higher real after-tax return

-higher real dollar purchasing power by 0.25% of asset base

-higher spending power- spendable percent of assets while still maintaining real value of residual assets is 3.19%, 2.7% and 2.2%of asset base, at inflation levels of -2%, 0% and +2%, respectively

Or, at an annual spend rate of 4% of assets, the rate of encroachment on the residual purchasing power of the remaining asset base is 0.81%/year, 1.3%/year and 1.8%/year at inflation rates of -2%(deflation), 0% and +2%, respectively. (i.e. starting with $1 at the beginning of the year, the last line in the table shows the remaining real buying power after spending $0.04 during the year.)

Scenario 2: Asset allocation is Stock: Bond = 0%: 100% (i.e. all fixed income)

Note that in this scenario when inflation is -2%, a deflationary environment (i.e. prices drop 2%), the interest rate is 0% (inflation plus 2%), your tax would be zero but the purchasing power of your assets has increased by 2%; or real after tax return is +2%.

Deflation: Some interesting perspectives

There is considerable argument back and forth between those who expect inflation or deflation. Right now the deflationist camp appears to be winning (perhaps only very temporarily). Even among deflationists there is a debate in the level of deflation that we might expect to see, ranging from just a decreasing  level of inflation, to very low levels of actual deflation (price changes around -1% which some argue could even be a good thing) and all the way to significant (destructive level of  5-10%) deflation. There is also significant disagreement as to whether deflation is always bad; some argue not. Here are some interesting perspectives.

In the May 2004 BusinessWeek article “The Roots of Deflation” Chris Farrell discusses and excerpts from his (2004) book entitled “Deflation: What Happens When Prices Fall”. The following quotes are worth considering:

“Deflation is built on three fundamental changes dating back to the late 1970s and early 1980s: (1) the embrace of market capitalism at home and abroad; (2) the spread of information technologies; and, most importantly for understanding the economy of the next half-century, (3) the triumph of the financier.”

“Deflation is not synonymous with depression. The conventional notion that a persistent decline in prices is always a disaster, an economic disease to be avoided at all costs, a depression in the making, is wrong. University of Minnesota economist Timothy Kehoe examined the record of deflation in 15 countries over 100 years. There were indeed a number of episodes when nations experienced both deflation and depression. But it was more common for economies to grow during periods of deflation.”

“Innovation, creativity, and risk taking are the essence of capitalist growth… Schumpeter is best known for his evocative metaphor “creative destruction”… But Schumpeter also emphasized the destructive side of his famous metaphor. The dynamism of capitalist competition is devastatingly painful… The current safety net is woefully inadequate for an intense competitive, high-tech, globally integrated world economy. The most important reform is to attach health care and pension benefits to the worker rather than the company (my emphasis).”

“The payoff from supply side investments and a worker better safety in an economy of rapid growth and a falling price level is a high standard of living than many people believe possible.”

However, the same Chris Farrell in July 2010 “Deflation risk”while still indicating that deflation is not bad in itself in a mild form, however in the extreme it could cause serious damage.

“Sometimes, mild deflation signals a weak economy that limps along, always vulnerable to bad news. Think Japan. However, it can also signal a vigorous, healthy economy. Think late 19th century America…The world is shifting from an era of structural inflation to one of underlying deflation. The combination of technological innovation, freer trade, out-sourcing, central bankers worldwide dedicated to fighting inflation, a more mature international monetary system, and all the rest act as a brake on price increases. And this is why I’m so concerned about the recent trend in prices. The underlying price trend is deflationary and now, on top of that, is the downward momentum unleashed by the Great Recession and anaemic recovery…The Fed and other central bankers had better start worrying about falling prices and taking bold steps to combat it.”

But Jonathan Ratner reports in the Vancouver Sun’s “Investors need not fear Japan-style decade of deflation in U.S.” because economists’ arguments such as: wages have been growing despite very high unemployment, strong productivity growth, product supply is much higher than demand, increasing population level, significant inflationary expectations(due to expansive monetary and fiscal policies) are positive for avoiding deflation (people are not waiting for prices to drop before they buy). The expectation at this time is for “continued disinflation not outright deflation.

In a recent Barron’s article Gene Epstein in “Deflation demystified”writes that “Maybe it’s unlikely that faster economic growth will be accompanied by, say, a 1%-2% annual decline in the broad-based price indexes, but stranger things have happened. And if a gradual price decline does happen, there is no reason why the Fed shouldn’t allow it….historically inflation has been defined as an increase in the money supply, and deflation as a decrease…An outright contraction in the money supply is indeed a potential problem, but ironically, the cure is a fall in prices, so that money and the cost of things can better adjust to each other. Historically, however, a fall in prices has generally occurred when goods and services grow at faster rate than the money supply”, rather than due to collapse of aggregate demand.

Bottom line

The purpose of this blog was to explore how concerned we should be about the current deflationary threat. Since crystal balls are at best cloudy (mine certainly is), we have no clue if, when or how long we’ll actually have a deflationary period; we also don’t know if it will be followed by a significant inflationary environment.

If deflation is mild, its after tax effects of retirees’ circumstances (who live off DB pensions and income from accumulated savings) would more than likely be favorable compared to the outcome in an inflationary environment. This is especially true for private sector pension recipients whose pensions are typically un-indexed or only very partially indexed. (Of course this is the case only so long as the company sponsoring the pension plan has not gone into bankruptcy protection with an underfunded pension plan and the pension plan was in Canada. In the U.S. and U.K. pensioners are relatively well protected against such eventuality by government run pension insurance schemes)

So the typically corrosive effect of taxes (especial on interest income outside tax-sheltered vehicles) actually decreases as inflation decreases or mild deflation sets in. This is a much more favorable outcome when compared to the seriously corrosive effects of inflation on retirees.